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I've heard that you should invest for retirement in the following order:

  1. 401k with employee match
  2. Roth IRA, until you hit the max
  3. Rest of your 401k

I was curious however. The money for a 401k comes from your pretax income, and you have to pay taxes when you withdraw it. The money for a Roth comes from your post-tax income, but you can withdraw it tax-free at retirement. (I am assuming this is the largest difference between the two, for money that is set aside for retirement).

It seems like it would be better to start with a larger base of money and grow that (e.g. the pre-tax option), paying taxes later, than it would be to pay now and withdraw later without any taxes. What makes the most sense?

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Re: "The money for a 401k comes from your pretax income". No, not necessarily. Some plans permit your 401(k) to have both pre-tax and post-tax contributions, and the post-tax contributions can be Roth contributions and/or traditional post-tax contributions. However, employer base and matching contributions are pre-tax, always, even when matching your post-tax contributions. See my answer at this other quesiton: money.stackexchange.com/questions/1598/… –  Chris W. Rea Oct 22 '12 at 17:07
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2 Answers

See Started new job. Rollover previous employer 401k to new 401k, IRA or Roth IRA? for a start.

Kevin, the discussion is far more complex than you might think. Say your account grows by X, (pretend it's 10 if you wish) and your tax rate is Y (25%?). If you take the initial sum, tax it at Y, but then grow it X, the result is identical to doing it in the reverse order. So $1000 to start can grow to $10,000, then after tax, $7500. Or $1000 taxed to $750, then grow to $7500.

For pretax deposits, the key is that you deposit those contributions at your marginal rate, i.e. the rate you'd pay on the last $X taxed. But withdrawals start at zero.

In the perfect scenario, you will save 25-28% tax on deposits, but at retirement, enjoy taxation at 0%,10%,15% for a large portion or all of the withdrawals.

(Note, others can suggest rates will rise, and they may be right. My answer is based on the current tax structure.)

A new earner, at 10 or 15% may be better off starting with Roth, and as they earn their way to 25% or higher slide over to pre-tax deposits. My 14 year old baby sits, and makes enough to fund a Roth, but pays no tax as she earns less than her own standard deduction for what that's worth.

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Part of the difficulty in this sort of planning is that you are also betting on future tax rates and comparing them with current taxes.

If you are in a low tax bracket now, but expect to be in a higher one when you take the money out, it is better to pay the taxes now.

If you are in a high tax bracket now, but expect to be in a lower one when you retire/take the money out, then it is better to defer the taxes until then.

If you think that future sessions of Congress will decide to tax withdrawals from Roth accounts, then you should contribute to traditional accounts.

The problem is that you don't know with certainty what the future will bring. So you have to make educated guesses about what might happen, and what you can do now to protect yourself from it. Ideally, plan so that even if the bad things happen, you will be reasonably comfortable.

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